Incentivise innovatively

Natalie Jones of PwC Legal Middle East explores non-traditional, cost-effective methods to reward and motivate employees at the workplace.

This article first appeared on the Oath

2020 has undoubtedly been a difficult year for most employers, with many being required to implement cost saving measures such as reductions in salary, unpaid leave and redundancies. Despite that, savvy employers are looking forward; proactively taking steps to retain key talent and seeking cost effective and innovative ways of doing so.

Traditionally, reward in the context of employment relationships in the UAE has taken the form of monthly wages (commonly comprised of basic salary together with various allowances), annual bonuses and, in some cases, commission or other variable payments. Long term incentive schemes (LTIPs) such as employee stock option schemes (ESOPs) and other arrangements linked directly to company performance have not been as prevalent in the UAE as elsewhere. However, there is increasing interest in LTIPs as a potential option for employers to incentivise key employees without depleting cash reserves in the short term or at all, depending on the plan structure.

WHY WOULD AN EMPLOYER INTRODUCE AN LTIP?

Traditional remuneration structures require significant cash reserves and liquidity and potentially create a strain on a company’s books. This is likely to be felt more acutely by startups (with typically limited cash reserves) and other companies in economic difficulty. Moreover, standard salary in return for work arrangements do not necessarily encourage exceptional employee performance or long tenure. In contrast, well-executed incentive arrangements can potentially incentivise without creating a greater financial liability; helping employers to attract and retain valuable employees.

In the context of retaining talent, LTIPs have two key additional advantages over traditional shorter term incentive schemes, such as bonuses. Firstly, as the name suggests, LTIPs are intended as ‘long term’ arrangements, meaning that any benefits issued pursuant to the scheme will take effect on a future predetermined date. LTIP benefits would, in most cases, be intrinsically linked to continuing employment, thereby incentivising employees to continue in employment with the employer. Typically, where an employee leaves employment prior to an agreed date (or leaves in other specific circumstances), any benefits owing under the LTIP will be forfeited. Secondly, LTIPs are generally structured to ensure that the output of participating employees is directly linked to a future tangible and clearly identifiable benefit, creating a ‘win win’ situation for both the employer and the employee.

In other jurisdictions, LTIPs can be used for favourable tax treatment on payments which would, in other circumstances, attract income or capital gains tax. This is less of a concern in the UAE in the absence of personal income tax and social security obligations. Despite that, financial impact and the timing of any liabilities under a LTIP will be a significant factor for employers in determining whether a proposed arrangement will provide value. Naturally, the most successful arrangements in the UAE will reduce the cash impact of rewards (relative to other structures), particularly in the short to medium term.

WHAT ARRANGEMENTS ARE AVAILABLE?

The most frequently used LTIP arrangements are:

ESOPs (including share option, gifting or purchase arrangements);
Phantom share schemes; and
Deferred bonuses.

There are advantages and disadvantages to each, as set out below.

ESOPs

Very broadly, ESOPs work by offering employees share options (generally at slightly under market value at the time of grant) with a lengthy vesting period. If employees continue to be employed with the company at certain predetermined future points, the stocks will vest and the employees will benefit from any appreciation in share value. ESOPs are more commonly used by startups (and, notably, by tech startups). However, larger or more established companies can introduce ESOPs and may be minded to do so in the current climate to conserve cash in the short term.

The obvious disadvantage of ESOPs, from an employee perspective, is that a benefit will only arise where stock value appreciates. It can also be costly to set up and administer ESOPs, compared to other arrangements.

Phantom Share Schemes

Phantom schemes are effectively hypothetical ESOPs, linking performance to share value but without ever transferring shares to employees. Instead, employees receive a cash reward referable to the performance of shares over a notional vesting period. This approach avoids the dilution of a company’s equity since it is not necessary to increase and then divest share capital. For that reason, phantom schemes may be preferred by existing shareholders. The lack of share transfer also creates another advantage in that the regulatory frameworks which govern share transactions do not extend to phantom schemes which are, in essence, contractual incentive arrangements (albeit that the relevant metrics of the scheme will align with the company's share value).Accordingly, phantom schemes tend to enable greater flexibility for companies.

Phantom share schemes can also be structured to provide benefit on full value (i.e. the value of the underlying stock and any appreciation) or appreciation only whereby employees benefit from the value of increase in stock (if any) over a specific period of time.

Deferred bonuses

Deferred bonuses work in the same way as standard bonus schemes with the benefit of delayed payment. Such arrangements are easy to set up and do not trigger regulatory or other concerns, in the majority of cases. They are therefore more common than ESOPs and phantom share schemes. As with other LTIP arrangements, deferred bonuses incentivise continued service (as payment will be linked to continuing employment) and delay the impact of bonuses on cash reserves. However, ultimately, the liability for cash payments will crystallise at an agreed point in time and should therefore be considered as a liability for the business.

Generally, the appropriate form of LTIP will be determined by the size and structure of the company as well as its overall immediate and longer term goals.

ONE SIZE DOES NOT FIT ALL

Despite the advantages which can be gained by implementing LTIPs, those benefits will be undermined without employee buy in. For example, ESOPs and phantom share schemes will generally work only where stock is likely to appreciate. Employees will not receive a return on depressed or depreciating stock. Arrangements linked to stock are not therefore a particularly attractive benefit in those circumstances. Instead, deferred bonuses may be preferred, subject to the company being in a position to meet its future liabilities under the bonus plan.

Generally, the appropriate form of LTIP will be determined by the size and structure of the company as well as its overall immediate and longer term goals. To determine the appropriate arrangements, there are many factors which will require scrutiny including:

which entity will issue and perform any obligations set out in plan documents. For example, it might be preferable in some cases for another group entity to be responsible rather than a UAE based company, particularly where the issuing company could benefit from tax advantages;
which employees will be eligible to participate. In some jurisdictions, there are limits as to how much of a company’s stock can form part of an ESOP;
whether there are any regulatory considerations or barriers, particularly from a securities perspective. Commonly, an offer of shares will trigger certain requirements in respect of documents and information which must be provided;
whether there are any particular reasons to avoid share transfers. For example, dilution of equity; and
if there is any appetite to set up a special corporate vehicle to hold a pool of shares.

In all cases, it is imperative that scheme documents accurately reflect the intention of the parties, particularly in relation to the circumstances in which payments or benefits will and will not be triggered and that governing law provisions are well thought out in advance of implementation.

Employers would also need to ensure ongoing compliance with applicable data protection obligations (particularly where employee data will be shared by group companies in order to administer the scheme(s)) as well as considering scheme rules in the context of legislation addressing discrimination or less favourable treatment. From a UAE perspective, this will be a material consideration for employers based in the Dubai International Financial Centre and Abu Dhabi Global Market.

In addition, policy documents should address any potential tax issues, setting out clearly the circumstances which might give rise to tax and which party is responsible for any liabilities in that regard.

CONCLUSION

Traditional methods of rewarding employees are increasingly being replaced or supplemented by innovative longer term incentive arrangements. There are clear advantages of implementing longer term arrangements, particularly in retaining key employees. Those arrangements can largely be adapted to fit specific requirements having regard to individual companies and their specific goals. However, it is important that arrangements are well thought out in order to ensure that they address the company’s goals whilst limiting financial impact.

Contact us